Erion Shehaj

When I have previously outlined our Blueprint real estate investing strategy, I have usually given examples that involved the leveraged acquisition of quality assets followed by an aggressive campaign of debt elimination to produce maximum cashflow at retirement. But as crucial as smart leverage can be to the investing success of some investors following our strategy, it is not required or necessary. At its very essence, our Blueprint is the road map from where you currently are to where you are trying to go at the end of your investment horizon. So in that spirit, the right investment strategy for you is determined and shaped by your current financial situation. For instance, an investor with limited capital will follow a very different path to retirement than another investor with a large enough capital base to generate sufficient debt-free income to retire tomorrow.

Next, let’s take a deeper look into the main reasons and motivations that push some real estate investors to the path of debt free real estate investing for income and appreciation.

Risk aversion to debt

Most investors that make the choice to avoid leverage completely do so to avoid the perceived risk that debt inevitably adds to their portfolio. And it does not matter that the added risk is usually accompanied by a higher, leveraged return on investment. A very conservative investor is content with a lower rate of return if they can avoid the risk of financing. They view leverage not as a temporary tool to grow your capital base in a shorter amount of time but as a fatal risk that could bring the whole thing down. And often they have the time and/or the patience to build their wealth at a slower pace as long as it’s done within their risk comfort zone. This isn’t neither right nor wrong – every investor should operate within “comfortable” risk and return levels. In the end, it does not matter how good is the return on your investment if you perceive it so risky that you can’t sleep at night.

Lack of access to investment property financing

The investor that sidesteps debt due to this reason does so out of necessity, not choice. Take as an illustration a 58 year old teacher that takes early retirement and has some liquid capital to invest. He gets a pension every month but it’s not enough to fully retire. And also it’s not enough to qualify for financing on an investment property. In this case, the only available option to this investor would be an all cash strategy to increase his monthly income through some well placed real estate investments. Another example would be that of a newly minted entrepreneur that just ditched his corporate shackles with plenty of capital to invest but with no regular 9-5 income to qualify for financing.

Lack of need for financing

In this case, the investor already has a large enough capital base that the unleveraged yield on that capital is sufficient to provide the income she’s seeking. File this under, “good problem to have”. Say you have an investor that has $1.5M in liquid capital to invest and they’re trying to create an income stream of $120k per year. This investor has no need to leverage that capital further – she could purchase $1.5M in paid off real estate and reach her desired income right away.

Lack of necessary time

One critical ingredient in the utilization of leverage as a tool to grow one’s capital base is time. Without sufficient time to execute a proper debt pay off, leveraging your capital is simply risk for the sake of risk. You should only take calculated risks if you have  a) an exact idea on how to eradicate that risk as soon as possible and b) sufficient time to carry out that idea. As an example, take a 65 year old investor that needed to retire last Friday at 11:30 – he just doesn’t have the time to execute a plan that involves the undertaking and paying off of leverage. The only option left is to use the capital that he has accumulated and generate the highest yield possible on quality asset(s).

The numbers

Now that we figured out some of the reasons why an investor would choose (or be forced down) the path of all cash real estate investing, let’s take a look at some of the numbers. Since the investor is not utilizing leverage, her return comes from exactly two places: Yield on capital and Appreciation. Yield on capital sounds like a big ten dollar term right out of a finance textbook but it’s actually pretty simple. If I purchase a property all cash for $140k, and after paying all operating expenses I have $11.5k in cashflow left over at the end of the year, my yield on my invested capital for the year is 8.2% (11.5k/140k). It would be the same as you going to the bank to open a CD where you put $140k and the bank pays you $11.5k in interest at the end of the year. Except that your banker would think you are on something if you asked for an 8.2% return these days! Depending on the relationship between the acquisition price and the incoming rent of the asset you acquire, your yield on capital on free and clear investment properties will vary from 7-9% annually.

On the lower end of that spectrum, you will find premium properties in highly desirable locations that are in high demand – which results in higher acquisition prices and lower yield. The higher end yield will come from more standard properties in good locations. But here’s where it gets interesting – the properties that produce lower yields have a higher potential for appreciation than their counterparts. So when it’s said and done, opting for a premium property at a lower yield may end up giving you a higher overall return. But in the end, it all comes down to the needs of the investor: If the investor is mostly concerned with income, the higher appreciation may not matter as they may never sell the property to realize it. Otherwise, if they’re just opting for an all cash strategy to avoid risk, going for higher quality assets may result in higher returns and lower risks over time – a pretty rare combination.

Last but not least, cash is still King – a generous monarch that at times allows an investor the patience to pursue and negotiate bargains on quality properties. This could be a dual boost to returns: 1) It would allow the investor to acquire the same income stream for a lower purchase price therefore increasing her yield and 2) the built in equity captured at purchase can act as instantaneous “appreciation” that can be tapped later. The challenge with pursuing bargains is to never lose sight of the quality of the asset you are purchasing. An inferior asset at a great price is not a quality asset. So as long as property standards aren’t compromised, patient chasing of good deals is the recommended route.

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Are you interested in debt free real estate investing? I can help lead you in the right direction. 713-922-2702 is my cell. Or if you prefer email, Contact Us

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As more and more investors come to the consensus that a well-crafted real estate investing strategy can help them achieve their financial goals (even the R word itself: Retirement) a fundamental question arises: How should you allocate your real estate holdings within a Blueprint real estate portfolio? Now, the whole notion of “allocation” within a portfolio containing 100% real estate assets may come across as unnecessary. But keep in mind that even in an “all-stock” investment portfolio, there are different types of stocks that bring different returns (and their accompanying risks) to the portfolio. In much the same way, different real estate assets bring different benefits and risks to a real estate portfolio.

Standard assets

These properties are consistent performers and reliable money makers: They are easy to lease and keep leased. Their weakness is that they don’t offer much in the way of property appreciation. Typically they follow the appreciation curve of the overall market or come just under it. These assets offer higher returns for moderate risk. They are recently built (under six years) or new properties located in areas that aren’t yet established to their full potential. Remember, if an area is already popular, it’s already too late for real estate investors. That train has already left the station – prices have risen to the level where price to rent ratios no longer allow for reasonable returns.

Approximate returns for this category of assets: Cash on cash returns of 15%+ and Internal rate of return of 17-18%. Prices range from $100k-$150k 

Premium assets

These properties are typically located in established and highly desirable neighborhoods. They offer moderate returns for lower risk when compared to the standard category. There is always high tenant demand for these properties which results in rising rents over time. They tend to be well cared for, older homes  (10-20 years old). Their strength is that they offer higher than overall real estate market appreciation so whatever they lack in cashflow returns they tend to make up on value increase over time.

Approximate returns for this category of assets: Cash on cash returns of 10%+ and Internal rate of return of 12-13%. Prices range from $150k-$200k 

Note: There are some properties that have no place in a long term real estate investor’s portfolio, regardless of the “outstanding” returns they appear to offer. The reason their “paper returns” are so high is due to the fact that their extremely high risk is “baked into” that return. That risk often takes the form of a property located in a rough neighborhood with high crime rates, low school quality, higher turnover and eviction rates and property damage from defaulting tenants. These assets are the real estate equivalent of penny stocks. Just say no and thank me later.

So back to the big question: What types of assets should be part of your real estate portfolio and how should they be allocated?

If you just purchase 100% standard assets, you will have good cashflow and return on investment but you won’t be able to take advantage of appreciation waves to the extent that you should. If instead, you purchase a portfolio full of premium properties, you would be relying heavily on appreciation to accomplish your goals. Without appreciation, the cashflow produced may not be enough to get you over the finish line within your investment time frame and that just smells a little too much like speculation for my taste.

The optimal solution is to own a combination of the two asset types within your portfolio so you can have the best of both worlds: Solid returns and appreciation. The exact allocation will depend on the goals of the investor, their available time frame for investing and their income level.

• Investors with short time frames to retirement (under 5 years) more than anything else need all the cashflow they can muster during their short capital base growth stage. They don’t have the luxury of time to wait for appreciation. These investors have no other choice but to build a portfolio made up of 100% standard properties.
• Investors with medium time frames to retirement (5-9 years) need a portfolio weighed heavily towards standard assets but should add some premium properties in the mix to take advantage of value appreciation. Exact percentages will vary with each individual investor’s situation but a good rule of thumb in this case would be a 80% standard, 20% premium allocation of assets within their portfolio.
• Last, investors with long timeframes to retirement( 10-15 or more years) do have times on their side so in their situation it makes financial sense for them to add even more premium properties. Generally we advise these investors to adopt a 65% standard, 35% premium allocation of assets within their portfolio.

When I bring up appreciation in a conversation with a client, they always have a conflicted look on their face. After all, I’ve just finished telling them moments ago, that we don’t account for any appreciation in our cashflow analyses for potential acquisitions. So now, why are  we even concerned with appreciation?

Appreciation is an elusive and manipulative animal. It’s hard to empirically quantify how much appreciation an area is likely to experience (if any) and when. As such, we cannot build our analysis based on a factor that may or may not come into play. But understand one thing – normal appreciation is an innate characteristic of real estate assets. It’s common sense: The cost of materials and labor to build new homes goes up every year in response to inflation. So the same property will cost more to build in 10 years than it does today. Home builders are in business to make money and they can’t make money unless they sell their homes for more than what it costs to build them. So therefore, the same home should cost more in 10 years than it does today – it’s just plain economics. So why should that matter to a real estate investor? Well, let’s look at the arithmetic. Say you purchase a 125,000 property and you invest 25,000 of your capital as a 20% down payment. If the value of that property appreciates by 10% to 137,500, your return on investment from that appreciation is 50%! That’s due to leverage- since your investment in the property is $25k, a $12.5k increase in value represents a 50% return – in addition to any cashflow returns you might have enjoyed that year. That’s why it’s a big deal and that’s why you should purchase assets that have the potential to capture it in your portfolio if your investing situation allows it.

Are you looking to build a real estate investment portfolio that can get you from where you are to where you want to be in the future? I can help so don’t hesitate to call my cell at 713-922-2702 or if you prefer email head over to our Contact page

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Every wise real estate investor’s journey begins with a clear, overarching investment strategy. This strategy is the roadmap to get you from where you are to where you are trying to go. So needless to say, to come up with a worthwhile strategy, you must know your destination and be able to distill it into specific, time limited and written goals. If you can provide your goals, our Blueprint real estate investing strategy can provide you with a path to get there. More specifically it will show you what type of assets to buy, how many, as well as where and how to buy them. Setting out on an investment path without such a plan all but guarantees you a long journey into the wilderness of investing confusion – jumping from one fad strategy to the next.

But as crucial as it is to have an overarching strategy, the really hard part starts now. It’s what makes or breaks the plan and separates the best from the rest: Execution.

Four Stages to execute our Blueprint real estate investing strategy:

1. Asset Accumulation
2. Capital Base Growth
3. Maximum Cash Flow
4. Exchange or Exit

Asset Accumulation

The first stage of executing your Blueprint investing strategy is Asset Accumulation. At this point you have the exact number of assets you must acquire in order to achieve your goal so we must begin the acquisition of these assets. This phase should be completed as fast as your income and assets will allow because it is a prerequisite of all other stages. If the necessary liquid capital and financing prowess is readily available from the start, you have nothing standing in your way but your own fears and doubts. It’s okay to tread lightly on the first deal or two just to get some assurances that the properties will be rented in a reasonable amount of time and for the same amount as the cashflow projections. But once you’ve exhausted that bit of skepticism, execute and complete the acquisition of the necessary assets right away. If instead you are facing liquid asset limitations at this stage, it helps to sit down and put together a plan of saving the necessary additional capital within the fastest amount of time your income will allow. Complete the acquisition of the assets you can acquire with your existing capital and figure out a way to save the remainder as soon as possible. Think about it this way: The amount of time it takes you to start the engine will be added to the trip time towards your destination. Yet another reason for speed at this stage is to lock in fixed low interest rates on your debt before they rise.

Capital Base Growth

Now that you’ve acquired the necessary assets and they’re stabilized with good long term tenants in place, you have positive cashflow coming in every month. At this moment you have a very important decision to make. You could opt to take the cashflow now and enjoy your returns while you accumulate wealth at the 30 year schedule set by your Lender. Or choose to use that cashflow to grow your capital base and build wealth now. The chosen path we advise our clients to take is to focus on building wealth first so later the cashflow from your real estate portfolio can reach critical mass and allow you to retire on it. To illustrate this concept, let’s say you put together a portfolio of five properties worth about $120k each which produces $4800 in positive cashflow per property per year and you hold these assets for 10-12 years. If you opt for income now while building wealth at a 30 year pace, you would earn $24k per year and you would build approximately $95k in equity during that period through debt paydown. Instead, if you follow our advice and grow your capital base first, in that same time frame you would have a free and clear portfolio worth $600k without a penny in appreciation during that period and that portfolio would produce $60k in annual income thereafter. Don’t get me wrong – $24k per year is nothing to sneeze at and it certainly would be very nice to have. The problem is that small money has a tendency to dissipate over time leaving investors wondering what happened to all that cashflow ten years later. I call this “Starbucks money syndrome” – when you don’t focus the power of your money to achieve a larger scale goal, it tends to turn into minutia.

Maximum Cashflow

Now that your real estate investment portfolio is free and clear, it’s time to enjoy your maximum cashflow stage. Since none of your incoming rent is going to service the debt, your portfolio is now free to produce income at it’s maximum potential at the very time when you need it most. You have arrived at your destination after a long journey of disciplined execution and now it’s time to enjoy the fruits of your wise decisions and your commitment to stick to them. So quit that job you no longer want to do, take that long trip you always dreamed of taking or fund that college for your grandsons and daughters. Whatever you imagined and hoped that your investment portfolio would do for you when you first started – Do. That. Thing.

Exchange or Exit

But wait, we’re not quite done yet. Just because you are rightfully enjoying the results, it does not mean that we let our guard down. With debt service out of the picture, all that’s left on the expense side of the ledger are operating costs. Since now is the time we need the income most, we need to be watchful and make sure that capital expenditures (major component replacements: roof, HVAC system etc) don’t eat up our precious income stream. So that may call for the investor to replace older assets with newer ones, or to exit an investment and cash in on the value appreciation it has incurred during the holding period. This can be done two different ways: A 1031 like kind exchange to defer property taxes on any capital gains/reclaimed depreciation or through a straight sale/exit of the investment. The road we will advise you to take will depend on several factors. The investor’s exposure to income taxes and any available tax shelters certainly come into play. Also, the investor’s plan may call for a shift of some of their capital base to a different type of investment.

Bonus

One more concept to think about here: What do you have most Time or Money? If you have plenty of time (15+ years) you can let the positive cashflow alone do all the work. If time is scarce (you need to retire last Thursday around 1:15pm), you have to employ your income to feed the wealth building fire so it burns quicker. Let’s take that one further: If you find yourself completing the plan and still have got time on your side, it’s not illegal to start again and pursue even bigger goals. 🙂 In my experience, I’ve found that one major limitation for investors is that their goals usually go as far as their current “horizon”. However, a beautiful thing happens when they reach a higher level: Their horizon changes. And so do their goals. So it’s okay to be limited by what you think is your current capacity to achieve as long as you allow yourself to reassess that capacity once you reach higher plains.

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